The ABCs and XYZs of Trusts

Trusts are fairly simple. Lawyers and estate planners make them seem more complicated than they are. That’s too bad, because to ensure they have effective estate plans nonlawyers need to understand the different types of trusts and how they work.

Trusts used to be for only the very wealthy or for special situations. But now trusts are included in many estate plans, because they can help achieve so many goals. Almost everyone needs a working knowledge of trusts, and you should brush up on them before the estate tax is changed later in 2009.

A trust is simply a contract with three parties. The parties can be groups, because more than one person can share any of the roles. A person can have more than one role, even all three.

One party to the contract is the grantor or creator. This is the person who wrote the trust agreement and usually puts all the assets in the trust. Another party is the trustee. The trustee agrees to manage the assets according to the terms of the trust agreement and the law. Legally the trustee acts as owner of the assets, but the actions the trustee can take are limited by the trust agreement. In addition, the assets cannot be reached by personal creditors of the trustee.

The third party is the beneficiary. Beneficiaries have rights to receive income or principal or both according to the terms of the trust agreement, and the trust assets are managed for the benefit of the beneficiaries. Sometimes beneficiaries have other rights, such as the ability to change trustees or name who receives their interests after they pass away. Either the beneficiaries or grantor normally can sue the trustee for violating the trust agreement or mismanaging the assets.

Trusts are very flexible. There are few limits to the terms that can be put in the trust agreement. To make their work easier, lawyers have shorthand names for trusts that are designed to achieve specific goals. The tax law also gives names to trusts with certain provisions. The flexibility and different names can make trusts seem confusing.

In general, it is easiest to think of trusts in four categories. In each category there are two possible labels. Most trusts have a label from more than one category and some from each category.

Living vs. post mortem. A living trust simply is a trust created during the grantor's lifetime. A post mortem trust is one created in or as part of the will. A living trust often is given the Latin name inter vivos trust.

Keep in mind a trust can be created but not funded. For example, a grantor and trustee can sign the trust agreement. That creates the trust. But the trust has no effect and there is no business for it to do unless property is transferred to it. It is not unusual for grantors to create trusts then fail to transfer title to any assets to them. Also a trust can be created during life but funded under the will.

When most people hear the phrase "living trust" they actually are thinking of a revocable living trust, which we will discuss next.

Revocable vs. irrevocable. A living trust can be revocable or irrevocable. In a revocable trust, the grantor reserves the right to revoke the trust or change its terms. The right to change might apply to some terms or to all the trust terms. For example, the grantor might reserve only the right to change the beneficiaries but not the rest of the terms. An irrevocable trust is what the name says. Its terms cannot be changed by the grantor after the trust agreement is signed.

A very common trust is the revocable living trust. It is used to avoid probate in states with high probate costs or long probate procedures, especially California and Florida.

Under the revocable living trust the grantor transfers title to almost all his or her property to the trust, including homes, cars, checking accounts, investment accounts, and household furnishings. The grantor and grantor's spouse usually are both the initial trustees and beneficiaries. They generally treat the property the same as they did before the trust was formed, except everything must be in the trust's name, and they manage it as trustees. The trust agreement spells out who succeeds them as trustees and beneficiaries.

Property owned by a trust is transferred to the next generation of beneficiaries under the terms of the trust agreement. A will has no effect, and property owned by a trust avoids the probate process. There is no public recording of the trust, and the trustees do not have to ask a court to transfer title to heirs. Instead, the trust agreement controls. That is why a revocable living trust also is called a will substitute.

There are serious tax differences between revocable and irrevocable trusts. When a grantor creates a revocable trust, the grantor is treated as the owner of the property for tax purposes, and the trust assets are included in the grantor's taxable estate. Income and gains of the revocable trust generally are taxed to the grantor as earned, whether or not money is paid from the trust to the grantor.

Irrevocable trusts can reduce income and estate taxes. When properly structured, irrevocable trust property is not included in the grantor's estate, and trust income and gains are taxed to either the trust or the beneficiary instead of the grantor. While irrevocable trusts can reduce taxes, they really must be irrevocable and the grantor cannot have the right to retrieve the property or be paid the income.

Income vs. total return. The next category refers to how annual payouts to the beneficiary are determined. Traditionally, the income beneficiaries of a trust receive only income earned by the trust's assets. Income generally is defined as interest, dividends, royalties, and rents. Capital gains are not income. They are added to trust principal. A standard trust term is to pay all income to the grantor’s spouse for life. After the spouse's demise, the children receive the remaining trust principal.

The income trust has become less feasible as interest rates declined and the cost of living increased. Income stays the same or declines as the income beneficiary's cost of living rises. The trustee could try to increase income by investing in riskier income vehicles, but that puts the principal at risk. Another tension is the remainder beneficiaries want some of the trust invested for growth. Otherwise, the purchasing power of their remainder interest declines because of inflation. But the needs of the income beneficiary discourage growth investing.

A total return trust solves these problems. The “income beneficiary” is paid either a percentage of the trust assets or a fixed amount. The trustee does not worry about restricting payouts only to income. Instead, the trustee invests for long-term growth with a diversified portfolio. The income beneficiaries can be paid from income, capital gains, or principal. The total return trust is the better way to structure trust payouts today.

Discretionary vs. nondiscretionary. This category refers to the trustee's ability to vary distributions or payouts. In a nondiscretionary trust, the trustee is told in the trust agreement how much to distribute to income beneficiaries each year or how to calculate the distributions. The trustee also is told when to distribute principal and how much to distribute. For example, one third of the principal might be distributed to a beneficiary upon turning age 21, another third at 25, and the remainder at 30.

A discretionary trust allows the trustee to exercise judgment at least part of the time. The trustee might distribute to the surviving spouse all income earned by the trust plus whatever principal or capital gains are needed to maintain the spouse's standard of living in the trustee’s judgment. Or the trustee might be able to withhold any distribution when the trustee believes it is in a beneficiary's best interest, such as when the beneficiary has a substance abuse or gambling problem.

These are the broad ways of categorizing trusts. There are many specialized trusts. There are charitable trusts (several types of them), dynasty trusts, grantor retained annuity trusts, grantor retained income trusts, and many more. These specialized trusts usually are used to accomplish certain goals at a minimum tax cost, and the tax law dictates the details of the trusts. But each of these specialized trusts also can be defined by the categories we discussed. They are specialized trusts within the categories.

Now, you know the basics of trusts. You can intelligently review and discuss estate plan options, know the key questions to ask about a trust and the consequences of the answers. You are ready to put together a more effective estate plan and to avoid having a trust you don't need or that does not meet your goals.


Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Posted 05-06-2009 11:17 AM by Bob Carlson
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